OEPARTEMENT TOEGEPASTE ECONOMISCHE WETENSCHAPPEN

Abstract For the purpose of testing uncovered interest parity (UIP), rates of European currencies against the DEM offer a distinct advantage: ERM membership or informal ERM association induces statistically significant mean-reversion in weekly rates. Thus, unlike for freely floating rates, there is an expectations signal that has nontrivial variation and is sufficiently traceable for research purposes. When running the standard regression tests of the unbiased-expectations hypothesis at the one-week horizon, we nevertheless obtain essentially zero coefficients for intra-EMS exchange rates (and the familiar negative coefficients for extra-EMS rates). Even more puzzlingly, lagged exchange rate changes remain significant when added to the regression, a feature that seems harder to explain as a missing-variable phenomenon. The deviation from UIP is significant not just statistically but also economically: trading-rule tests reveal that for sufficiently large filters the average profit per trade exceeds transaction costs, and that cumulative gains can be quite impressive. The size of the profits and the patterns from buy versus sell decisions also allow us to reject the risk premium and the Peso hypotheses as separately sufficient explanations. JEL classification: F31. Key words: forward bias, transaction costs, trading rule, EMS, ERM